When preparing a private software company for an exit strategy, the first question that may arise is “What is my company worth?” There are no simple answers to this question, but being prepared, using the appropriate valuation metrics, and understanding accounting standards can make the difference between getting a fair market value for your company or leaving money on the table.

One of the most popular methods used by analysts in valuing a company is the price-to-earnings (PE) ratio, which is a multiple of net income. The PE method is typically a good measure for publicly traded companies with a long history of profitable earnings. However, using a net income multiple to derive a value for a privately held, young and fast-growing software firm can have significant price ramifications. The record of private companies frequently doesn’t reflect the true cost of business. For example, earnings may be artificially low because the owners have been charging the company rent on a facility they own, taking royalties out of the company, or paying themselves large salaries and bonuses. As a result, financial statements must be recast.

To get a better measure of how much money a company is generating from operation and to derive a better valuation, owners should focus on EBITDA (Earnings Before Interests, Taxes, Depreciation, and Amortization). Interest expense is the result of financing decisions; buyers typically do not assume the debt as part of the acquisition. Taxes are also not under consideration since any investment that the buyer makes that yields a positive return will be taxed at their corporate tax rate. Depreciation and Amortization are an accounting requirement and not a cash-related activity that should be included in valuation.

As a manager managing your business, a lot of focus is placed on the bottom line. From a valuation perspective, the bottom line of a private software firm doesn’t always tell the whole story. More focus should be place on EBITDA to derive a more accurate picture of the operating performance and a fair valuation of the company. 

A version of this article originally appeared in Soft•letter and Software Success